Yield vs. Interest Rate: An Important Financial Distinction

In the financial industry, some terms may often have nearly the same meanings. Yet, for those who intend to make money, even these minor differences may be substantial. 

If you compare yield vs interest rate, you may find that these two financial tools fall exactly under such a category. Both of them refer to the ways of calculating returns on investments.

However, there is still a crucial difference that may mean a lot for investors. At this, it’s very important to understand how they differ from each other, especially when it comes to making money in crypto in unstable market conditions.

"Interest is the same as yield. The difference in conversation is minor, but major at scale. We open ourselves to regulatory scrutiny and alienate sections of the world. A few words is more important than a few dollars."

- WaLLrus

Yield vs Interest Rate

In TradFi, whenever you invest in fixed income securities such as bonds, you earn monthly or annual interest payments. 

At this, the interest rate reflects the cash flow that you get while holding these securities. In fact, this is the cost that the borrower pays you for taking your money expressed in a percentage of the sum you’ve lent.

However, as you inevitably bear some additional expenses like commissions or broker fees, the interest rate does not equal net profits. 

The yield comes helpful when you need to estimate the final ROI. This is the total return that you get after having extracted all the payments from the interest rate.

Example of Interest Yield vs Interest Rate Calculation

Now let’s take a look at some real-life examples to illustrate the difference.

Imagine a bank customer taking a loan of $1,000 with an annual interest rate of 10%. Thus, after a year, he will owe the bank $1,000 + ($1,000 x 10%) = $1,100.

At this, the bank earns $100 of the net profits. 

However, it also bears some expenses in the process. It spends $8 on bookkeeping and pays another $12 as a salary to the worker who manages the loan.

As a result, the bank’s actual yield will equal $100 - ($8 + $12) = $80.

Interest Rate Risk of Long Term Bonds vs Short Term Bonds

In the TradFi, it is particularly important to correctly estimate yield for the risk assessment when investing in long term bonds. 

At this, the prices of such bonds strongly depend on their interest rates. Whenever these rates increase, the prices of bonds go down, and vice versa. At the same time, those who hold long-term bonds are subject to greater risks. There are two key reasons why this happens.

First, in the long run, the chances of the interest rates rising are much higher than in the short-term period. In this case, investors will get higher interest payments. However, if they try to sell the bonds before their maturity, they will have to do that with large discounts and lose the yield they’ve obtained.

With short-term bonds, in turn, interest rates are more likely to stay the same. Therefore, the risks are much lower.

Second, long-term bonds’ prices are much more sensitive to changes in interest rates. Even a minor change in the interest rate may significantly impact the final coupon rates given that the investor holds it for a significant period of time.

Therefore, despite fixed rate income, the risks of holding long-term bonds are much higher.

How Does the Interest Rate Work in Crypto?

If you compare the concepts of yield vs interest rate in the crypto industry, you will see that they have a lot in common.

Users may stake their coins on different platforms and protocols and earn interest rates for that. To withdraw their income, they pay various fees and get yields to their personal wallets. Thus, the crypto yield will be lower than the interest rates just like in the case of bond yield.

Though the process looks similar on the surface, it differs from the technical perspective. At this, the concept also known as yield farming relies on a variety of different means to help crypto holders earn interest. Here’s what the interest rate in crypto may comprise:

• Trading fees. Liquidity providers who are the backbone of decentralized exchanges contribute to the work of such platforms by locking some amount of liquid crypto in liquidity pools. For that, they earn a portion of trading fees generated by transactions in these pools.
• Protocol fees. Some of the blockchain protocols share their revenue with users in the form of protocol fees. For example, traders on SushiSwap have to pay a 0.3% fee per transaction. This sum is then shared between liquidity providers and xSUSHI holders who get 0.25% and 0.05% correspondingly.
• Lending fees. Decentralized protocols for lending and borrowing crypto combine all assets in the shared pools. Users who lend their crypto to such pools earn lending fees from the loans that other users take from these pools.

The fees are not the only source of generating interest in crypto, though. Blockchain projects launch different reward programs to incentivize the most active users. 

Also, some protocols offer a variety of other tools to help users maximize their profits. They may offer automated portfolio rebalancing, crypto arbitrage, yield farming, and more. 

All these techniques serve to increase the final interest rate that users may earn on their investments.

How Does Yield Farming Work in Crypto?

When applied to crypto, yield farming represents the process of generating income from your crypto holdings.

The most basic scenario works as follows.

Users lock their funds in liquidity pools of DeFi protocols to provide the last ones with liquidity. As they help traders execute their orders and facilitate lending and borrowing processes, they earn their interest rates as a share of the fees the protocol imposes on every transaction.

However, their final earning will be different as they have to pay various fees before withdrawing their funds. At this, they pay platform taxes, network fees, and a variety of other commissions. The crypto yield is the final sum that they get to their personal wallets represents 

Yield farming is essential to incentivize liquidity providers. Thanks to blockchain, this new method of generating income bears a number of advantages when compared to traditional bonds and other securities. Investors have full control over their own funds while they can easily rebalance their tokens across different tools to maximize the final yield.

Risks of Yield Farming in Crypto

New technologies come with new risks as well. Here’s what investors should keep in mind should they want to make profits via yield farming:

• The risk of a “rug pull”. New DeFi startups that haven’t yet earned a proper reputation may intentionally drain assets from liquidity pools. 
• Bugs in smart contracts. Any weakness in a smart contract may lead to a security breach and eventually funds losses.
• Volatility. Finally, yield farmers can easily lose money if the assets they stake suddenly drop in value. Also, their positions can be automatically liquidated if the value of the collaterals they provide is no longer sufficient.

Yet, despite all these risks, yield farming represents a much more lucrative option for investing your funds in comparison with TradFi. 

New technologies make it possible to earn much higher interest rates, and, as a result, higher yields. At the same time, the possibility of fully controlling your own funds makes the new solution much more attractive.